Best ETFs in Small-Cap, Mid-Cap Space

Small-cap and mid-cap stocks have been able to find relative refuge amid the market turbulence, and there are a number of ETF choices that can take advantage of this trend.

ETFs that track these two areas have been outperforming the market in the first half of the year. The iShares S&P Small Cap 600 Index ( IJR) is trading right around where it was at the beginning of the year, while the iShares S&P Mid Cap 400 Index ( IJH) is up 2.5% year to date.

Overall, these might not be eye-catching performances, but they compare quite favorably to the S&P 500, which is down 7.3% so far this year.

The returns that these ETFs have afforded investors underscore the value that can be achieved with even a slight degree of fine-tuning to an index investor's portfolio.

"There is plenty of benefit in being somewhat active in picking niche sub-index ETFs," says Will McClatchy, Founder and Editor of ETFZone.com. "If you want to be active, pick sub-index ETFs."

Sub-index ETFs have been gaining an increasing amount of attention as the broader markets have continued to remain volatile. Within the small-cap and mid-cap space, there are ETFs geared toward growth investors as well as value investors.

The Vanguard Small Cap Growth ETF ( VBK) has been ahead of the market thus far in 2008 with a -0.5% return. Its holdings include names such as Priceline.com ( PCLN), Petrohawk Energy ( HK) and FLIR Systems ( FLIR).

Another sub-index ETF that has performed particularly well relative to the S&P 500 is the iShares S&P Mid Cap 400 Growth Index ( IJK). It is up 3.7% year to date and holds positions in companies such as Southwestern Energy ( SWN), Intuitive Surgical ( ISRG) and Cleveland-Cliffs ( CLF).

Second-Half Outlook

"If you believe the credit crisis is not over, small-caps would be a better place to hide than large-caps," McClatchy said. "The market has been so fixated on weakness in the financial sector and on commodities that attention has been driven away from the difference between these asset classes."

There are some obstacles that will likely remain in the way for both small-caps and large-caps.

"Valuations seem to be improving, but sentiment does not," said Robert Maltbie, Managing Director of Singular Research, an independent research firm that focuses on small-cap companies. "It has been a fairly garden variety bear market and we are probably only about half way through it. There has been a continued economic slowdown from higher oil prices."

Maltbie notes that small-cap companies with a global reach have been holding their ground, but current market conditions might play into the hands of investors who choose to go with individual stock picking as opposed to ETFs. "We are finding companies with exposure to emerging markets are working," Maltbie said. "It is a real stock picker's market right now though."

Maltbie looks for names that beat their estimates by sizable margins. Two small-cap names on his radar right now are Graham ( GHM) and Balchem ( BCPC).

Graham is a manufacturing company that has seen strong growth in the sale of its vacuum and heat transfer equipment. "Its growth is more of a secular trend than a cyclical trend," Maltbie said.

Shares of Balchem are sitting near their 52-week high as the nutrition products company is coming off of a record first quarter that included a 31.6% increase in diluted EPS.

Taking the High Road

It will be interesting to see if small-cap and mid-cap ETFs are able to maintain their relative strength in the second half of the year. If the broader markets continue to face resistance, this trend could face a correction.

"The small- and mid-caps are a little different from other major market sectors in terms of trend," says Dave Fry, Founder of ETF Digest. "However if the economy weakens further, these sectors, particularly small-caps, will face a tougher road higher since investors will be more apt to avoid risk and high P/E stocks more normally found in these sectors."